Saturday, May 9, 2009

Muddling through – why the American banking system will not turn Japanese – Part II

Welcome again to TPM readers. My first post on TPM got more comments than the average post on my own blog. And because the goals of the readership (policy/politics versus investing) are different I get a different perspective in the comments – which I find valuable.

In the last post I described an absolutely typical Japanese regional bank (77 Bank). The bank had massive excess deposits. The marginal cost of funds to the bank was about 10-15bs and almost all of that was deposit insurance fees.

The place was awash in cheap funding (deposits).

Well somewhere in my economics undergraduate degree (like the first week) I learnt that marginal costs tend to determine the price of things – and yet I see lots of fairly big name macroeconomists forgetting this.

In banking the biggest single determinant of the price of a loan is the marginal cost of funds. Its not the average costs of funds that matters – it is the marginal cost.

Loans are usually quoted in spreads – which is spreads over some index (swaps, treasuries). But in almost all times the spreads are a (under) a few hundred basis points and the biggest determinant of the rate is the risk free rate not the spread.

Now in a land where the banks are awash in funding the marginal cost of funds is pretty close to zero. Welcome to Japan.

But American banks are not awash in funding – and given the profligacy (especially historic) of the American consumer – not to mention tax cut funded Iraq wars and the like – the US financial system is almost always going to be an importer of spondulicks. That might change in twenty five years – but it is not changing now.

Because American banks – at the margin – are simply not awash in funding the marginal funding will be expensive – whereas in Japan the marginal funding is cheap.

And because of that loans will be expensive. They will always cost at least a few percent (whereas in Japan you can often get mortgage funding for less than one percent).

Now the average cost of bank deposit funding will not necessarily be high. Banks with large deposit franchises (such as Bank of America) have a lot of very cheap deposits. At Bank of America the interest free deposits are almost 250 billion dollar. The marginal funds are expensive – the average funds may not be. Loan spreads at the margin may be low one day (not yet) but loan spreads on average will remain healthy.

Banks in America have – at least by Japanese standards – very fat margins. Wells Fargo has the fattest margins of pretty well any major bank in the world (which is why Warren Buffett likes it so much). I have previously written about the large and increasing revenue of Bank of America here (and other places).

The high levels of revenue are what is recapitalising the American banking system. It is why the American system will muddle through and be right again within a couple of years.* Whereas the low revenue in Japan (resulting in 3% returns on equity in fully capitalised banks without credit losses) means that recapitalisation takes decades.

Now the banks can’t muddle through in America without government support – and they could not muddle through in Sweden or Korea or any other funding short country with collapsed banks without government support either. The reason is that the government support is necessary to raise the funds that the banks are (at the margin) short of. The crisis is precisely when the market no longer trusts the banks with funds without a government guarantee. But provided they get that government support they recapitalise nicely. Even in extreme cases like Norway where the banks were largely nationalised the government wound up making a profit on the bailout. [The nationalised banks were guaranteed.]

In Japan by contrast the banks were desperately insolvent – but for the large part they did not need government support. Why? Because they had excess deposit funds and it is very hard to go bust when you are awash with cash. You can however stay a zombie for decades because you do not have enough profit to recapitalise yourself (of to deal with small losses which are inevitable in banking).

It’s a paradox… the banking systems that are short of funding (such as America, Scandinavia, Korea and Thailand) have the highest need for government support in the crisis and the greatest prospects to muddle through without being zombies five years hence.

The policy question is how much government support the banks should get and for what fee to the government. One view (sometimes expressed on this blog) is that real capitalists nationalise. The returns should – in a capitalist system – go to the party that takes the risk. With government support that party is the taxpayer – and the returns should thus go to them. That is what the real capitalists in Norway did.

But in Sweden some banks were supported without being nationalised – and private shareholders did very nicely. Most countries wind up with a combination of public support for private shareholders and nationalisation. (In Korea for example Woori is a combination of banks that were fully nationalised whereas Kookmin is by and large a combination of banks that were only partly nationalised.)

That said – the US government policy is to support the banks largely without taking ownership (Citigroup excepted). If they keep this policy (and there seems little doubt that they will) then the banks will recapitalise over time through their very high revenue bases. Bank shares will – in most cases – recover.

Sure the taxpayer takes the risk without getting (much) upside. Its lemon socialism – take the risks and the losses at the taxpayer level – and given the full benefit of the bank revenue expansion to shareholders. It is not a great policy. I do not approve – but I approve more than I might otherwise because I am an Australian (and hence not an American taxpayer) and I managed to buy some Bank of America shares real cheap.

And for that, this non-American taxpayer thanks you.

Disclosure: still long BofA. It goes back to its all time high market capitalisation – and if they manage to avoid too much dilution (ie new share issuance at low prices) then it will go back somewhere near its all time high stock price.

John

*Muddling through within a couple of years may not be a desirable macroeconomic outcome (though it may be a good political for Democrats because the system will come good for the next Presidential cycle). In Korea the recession was great-depression deep. But the system came through. Countries that dealt with problems quickly (by a combination of nationalisation and full bank guarantee) tend to deal with the macroeconomic crisis better (though sometimes at the expense of bank shareholders).

PS. The really observant will notice that both Kookmin and Woori have English language websites whereas 77 Bank does not. The reason is that the Korean banks need to raise money - and they thust must talk the language of capital markets (English) whereas 77 Bank is awash in funds and can afford to speak Japanese only.

6 comments:

Anonymous
said...

John,

Can you comment on the drastic decrease in revenues in these various surplus countries? For example, Japanese savings today is virtually zero percent. Oils are dramatically lower, and only surplus are China and Saudi Arabia. In general revenues in all countries are going to go down significantly. Would this mean that there will be much less to lend everywhere, and interest rates are likely to go higher, and risk of xxflation, in-, or de-, or stag- is very real?

One interesting comparision to prove your point is to look at the 3 month Canadian interbank bankers acceptance rate vs the 3 month USD interbank Libor rate which are the marginal funding rates for CAD and USD based lending respectively. Both should be the same because the Fed and Bank of Canada both have target rates of 0.25% but the CAD bankers acceptance rate is around 0.40% while the 3 month USD Libor is just under 1.00%. The difference can also be seen in less stark terms by looking at the Tokyo interbank offering rate vs Libor.

But American banks are not awash in funding – and given the profligacy (especially historic) of the American consumer – not to mention tax cut funded Iraq wars and the like – the US financial system is almost always going to be an importer of spondulicks. That might change in twenty five years – but it is not changing now.i think this is really the big question, isn't it? were not japanese banks in more or less exactly this position in 1991-2, but with corporate rather than consumer credits sucking up all available lending capacity?

western banks are collecting fat spreads right now, but the true long-term test for the system won't be in loan supply -- it's in loan demand. if banks can't make sufficient new loans to replace the fat ones rolling off their books, earning power will diminish over time even as asset prices continue to deteriorate.

as i understand it, japan ended up with massive excess funds in banks because (beginning in 1996) the private sector started to repay loans (ie, aggregate loan demand went negative), to the tune during the early 2000s of 5% GDP. but in 1989, the japanese nonfinancial corporate sector was increasing its bank debt at a rate of in excess 12% of GDP (and issuing debt on the order of 5% GDP in capital markets to boot). that massive 17%-of-GDP swing in private credit took ten years to effect. aggregate private sector loan repayment seemed to have ended in 2005, but has probably resumed in this crisis.

to prevent a crash in monetary aggregates, the government borrowed out these excess deposits, which at 77 bank shows up as a massive investment portfolio in JGBs.

for what it's worth, i think a more appropriate comparison would be to the 77 bank of 1991. i have a sneaking suspicion that 77 bank was then also a mirror image of the current 77 bank, but i'd love to be disabused of that notion.

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